EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a way to measure how well a company is doing by looking at its profits from day-to-day operations, without considering costs related to loans, taxes, or the value of assets going down over time.¹
This makes EBITDA a valuable tool for investors, analysts, and business owners who want to understand a company’s overall operational performance.²
How to calculate EBITDA
To figure out EBITDA, you start with the company’s net income (total earnings) and add back interest, taxes, depreciation, and amortization. Here’s the formula:¹
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
This calculation shows a company’s earnings before taking away these specific expenses, giving a clearer picture of its basic profitability.
EBITDA vs. net income vs. contribution margin
EBITDA considers earnings before paying interest, taxes, depreciation, and amortization, while net income refers to earnings after paying for those expenses. Contribution margin, on the other hand, indicates how much revenue is left after subtracting variable costs to cover fixed expenses and generate profit.
EBITDA for businesses
EBITDA became popular in the 1980s, especially with leveraged buyouts where, companies were bought using a lot of borrowed money.³ This metric provided a quick way to assess whether a company could generate enough cash flow to service its debt and support its operations.
Businesses can use EBITDA for:
- Budget planning: EBITDA helps you gain a comprehensive view of your company’s financial stability, helping you decide when to invest in new resources, like technology or machinery.
- Staff reduction decisions: Analyzing EBITDA can make staff reductions a little more straightforward and objective according to financial necessity.
- Selling the business: When considering selling your business, EBITDA can be a powerful tool, allowing you to present your company as a profitable venture to potential buyers and helping you establish a realistic asking price.
What is a good EBITDA?
A good or high EBITDA can attract investors because it suggests the company is making good profits from its core operations. This can be especially important for companies in industries with high capital expenditures, where traditional net income might not fully capture the company’s profitability.
However, a high EBITDA doesn’t always mean a company has good cash flow, especially if it has a lot of debt. The U.S. Securities and Exchange Commission (SEC) requires companies to explain how they calculate EBITDA and forbids them from showing EBITDA on a per-share basis to avoid misleading investors. This transparency ensures that investors understand the context in which EBITDA figures are presented and can make more informed decisions.⁴
EBITDA drawbacks
- Ignores capital expenditures: EBITDA does not account for capital expenditures, which are essential costs for maintaining and growing a company’s asset base. Companies with significant capital investment needs may appear more profitable than they actually are.⁵
- Overlooks changes in working capital: EBITDA does not consider changes in working capital, which can impact a company’s short-term financial health. Issues with collecting payments or managing inventory can be overlooked, giving a misleading picture of liquidity.⁵
- Potential for manipulation: Since EBITDA excludes many expenses, it can be manipulated to present a more favorable financial picture. Companies might highlight EBITDA to divert attention from poor net income or cash flow performance.⁵
- Excluded non-cash expenses: While EBITDA adds back non-cash expenses like depreciation and amortization, these expenses represent the wear and tear on assets and the true cost of long-term investments. Ignoring them can lead to an incomplete understanding of a company’s financial obligations.⁶
- Misleading for debt levels: High EBITDA does not necessarily mean a company can service its debt. Companies with high levels of debt might still face financial difficulties despite having a strong EBITDA, as interest payments and principal repayments are not considered.⁶
- Not a standardized measure: EBITDA is not governed by generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS), leading to variations in its calculation. This lack of standardization can make comparisons between companies less reliable.¹,⁶,⁷
Be aware when using EBITDA
EBITDA is a helpful metric for understanding a company’s profitability from its core operations. It provides a way to compare companies without the influence of financing and accounting decisions.
Use it along with other financial metrics to get a full picture of a company’s financial health. Investors, analysts, and business owners should be aware of both the benefits and the potential pitfalls of relying solely on EBITDA.